Buying Options vs Selling Options

Understanding Option Buying and Selling

Options contracts are financial instruments derived from underlying assets like equities, currencies, commodities, or bonds. These contracts grant the buyer the right, but not the obligation, to buy or sell the asset at a predetermined price on or before a specified future date.

There are two primary types of options: call options and put options. A call option gives the right to buy the underlying asset, while a put option provides the right to sell it. Both call and put options can be bought or sold, depending on the trader’s outlook and strategy.

The difference between an option buyer and an option seller lies in their roles and risk exposure. The option buyer pays a premium to secure a right without obligation, like an insurance buyer. Meanwhile, the option seller also called the writer accepts the obligation and earns the premium, much like an insurance provider.

From a profitability standpoint, buyers can earn unlimited returns with limited losses, whereas sellers face limited profit potential but carry unlimited risk.

The Power of Leverage in Options Buying

When you buy options, whether call or put, you gain exposure to price movements at a fraction of the actual cost of the underlying asset. This is called leverage.

For instance, owning a long call means you have the right to buy the asset before expiry, while a long-put grants the right to sell before expiry. In both cases, you're paying a relatively small premium for a much larger exposure.

A Practical Illustration

Suppose your m.Stock trading account has a balance of ₹60,000. A call option contract on a stock trading at ₹800 is available for ₹20 per share for 1,000 shares. If you were to buy the stock outright, you’d need ₹8,00,000. But with options, you only pay ₹20,000 (₹20 x 1,000). With ₹60,000, you can buy three such lots.

If the option price rises by ₹10, your total gain is ₹30,000 (3,000 x ₹10), resulting in a 50% return on investment. A similar strategy can be used with put options if you anticipate a stock’s price to decline.

This is the beauty of leverage: higher returns with clearly defined risks, the maximum loss being the premium paid.

Understanding Option Buying and Selling

Options contracts are financial instruments derived from underlying assets like equities, currencies, commodities, or bonds. These contracts grant the buyer the right, but not the obligation, to buy or sell the asset at a predetermined price on or before a specified future date.

There are two primary types of options: call options and put options. A call option gives the right to buy the underlying asset, while a put option provides the right to sell it. Both call and put options can be bought or sold, depending on the trader’s outlook and strategy.

The difference between an option buyer and an option seller lies in their roles and risk exposure. The option buyer pays a premium to secure a right without obligation, like an insurance buyer. Meanwhile, the option seller also called the writer accepts the obligation and earns the premium, much like an insurance provider.

From a profitability standpoint, buyers can earn unlimited returns with limited losses, whereas sellers face limited profit potential but carry unlimited risk.

The Power of Leverage in Options Buying

When you buy options, whether call or put, you gain exposure to price movements at a fraction of the actual cost of the underlying asset. This is called leverage.

For instance, owning a long call means you have the right to buy the asset before expiry, while a long-put grants the right to sell before expiry. In both cases, you're paying a relatively small premium for a much larger exposure.

A Practical Illustration

Suppose your m.Stock trading account has a balance of ₹60,000. A call option contract on a stock trading at ₹800 is available for ₹20 per share for 1,000 shares. If you were to buy the stock outright, you’d need ₹8,00,000. But with options, you only pay ₹20,000 (₹20 x 1,000). With ₹60,000, you can buy three such lots.

If the option price rises by ₹10, your total gain is ₹30,000 (3,000 x ₹10), resulting in a 50% return on investment. A similar strategy can be used with put options if you anticipate a stock’s price to decline.

This is the beauty of leverage: higher returns with clearly defined risks, the maximum loss being the premium paid.

The Downsides of Option Buying

While leverage is a major plus, option buying comes with time decay risk. As the expiration date nears, the time value of options diminishes, which can erode potential profits. Moreover, not all stocks have liquid options, and even if they do, thin volumes can lead to high impact costs. This restricts flexibility in hedging or executing trades efficiently.

Option Selling: Earning Premiums Upfront

Selling options involve collecting the premium upfront. This can be done by writing a call or a put option. If these expire worthless, the seller keeps the full premium. However, this approach demands larger capital and margin requirements, making it a strategy suited for more seasoned and well-funded traders.

While profits are capped, the risk is substantially higher due to the obligations involved. If the buyer exercises the option, the seller must deliver (in the case of calls) or take delivery (in the case of puts).

There are two broad categories of option selling:

• Covered options
• Naked options

Selling Call Options: Covered vs Naked

• Covered Call: You sell a call option on a stock you already own. This is ideal when you don’t expect the stock to rise significantly before expiry. The premium adds to your income, and risk is limited since you already hold the stock.
• Naked Call: You sell a call option without owning the stock. If exercised, you’d need to buy the stock in the market to deliver, which exposes you to unlimited risk. This makes it a high-risk strategy suitable only for advanced traders.

Selling Put Options: Covered vs Naked

• Covered Put: Here, you sell a put option while also holding a short position in the underlying stock. This is used when expecting the stock to fall.
• Naked Put: You sell a put without holding a short position. If exercised, you must buy the stock potentially at a loss making this strategy capital-intensive and risky.

Conclusion: Which is Better?

Both buying and selling options have unique characteristics:

• Option buying requires less capital, offers high return potential, and has limited risk but comes with the challenge of time decay.
• Option selling is an income-generating strategy with upfront gains but demands high margin and carries significant risk.

Traders on m.Stock should assess their risk tolerance, capital availability, and market view before choosing between these two approaches.

Things to Remember

• Call Option is equal to Right to Buy
• Put Option is equal to Right to Sell
• Options can be both bought and sold depending on strategy
• Option buyers pay premiums for potential gains and risk control
• Option sellers collect premiums but take on greater risk
• Buying options gives leverage and defined loss limits